Important Reminder: Section 162(m) Performance-Based Compensation Plans May Need Reapproval to Avoid the Deduction Limitations

November 15, 2010

With the new year quickly approaching, many companies are well into the process of considering whether to seek shareholder approval for additional share authorizations for their equity plans. In connection with this review, publicly-held companies that have any type of performance-based incentive compensation plan should also review whether performance-based goals need to be reapproved by shareholders at the next annual meeting pursuant to the regulations under Section 162(m) of the Internal Revenue Code, as amended (the “Code”).

Section 162(m) of the Code imposes a $1 million annual limitation on the deduction for compensation paid to each of the CEO and the three most highly compensated executives, other than the CFO, of publicly-held companies. However, “performance-based” compensation is not subject to the deduction limitation of Section 162(m), as long as it meets certain requirements. One such requirement is that the material terms of performance goals must be disclosed and approved by shareholders before the performance-based compensation is paid. For companies whose compensation committee has the authority to change the targets under a performance goal following shareholder approval, Section 162(m) regulations require that the performance goal be reapproved by shareholders no later than the first shareholder meeting that occurs in the fifth year following the year in which shareholders previously approved the performance goal.¹ In other words, reapproval of the performance goals by shareholders is needed at least every five years.

We remind public companies to check the date of the last shareholder approval for performance-based plans, and to ensure that the last shareholder approval covered performance goals for purposes of Section 162(m). Both cash and stock incentive plans may need reapproval at least every five years. If a company’s plan last received approval in 2006, shareholders may need to reapprove material terms of performance goals this coming year.

Not all plans that qualify for the performance-based compensation exception require reapproval every five years. Shareholder reapproval is not necessary if a company relies on an approach to plan design that is commonly referred to as a “plan within a plan” or an “umbrella” plan. Under that approach, generally, a fixed formula (often based on a percentage of earnings) is approved by shareholders and dictates the maximum amount of the payment to the covered executives. The compensation committee retains negative discretion to reduce payouts below the maximum, subject to whatever objective or subjective criteria the compensation committee may wish to apply from year to year. Similarly, a plan that permits only stock options and stock appreciation rights to be granted at fair market value will not require reapproval.

Please call any of your regular contacts at the firm or any of the partners and counsel listed under Executive Compensation and Employee Benefits if you have any questions.
¹ Treas. Reg. § 1.162-27(e)(4)(vi).